Chapter 5

Analysis and
Interpretation
of Financial
statements
Christine Talimongan
ABM - Bezos
Contents
 Liquidity
 Solvency
 Stability
 Profitability
 Vertical Analysis
 Horizontal Analysis
 Financial Ratios
 Current ratio
 Working capital
 Gross profit ratio
 Net profit ratio
 Receivable turnover
 Inventory turn-over
Add a footer  Debt-to equity ratio 2
 FR

Introduction
 The objective of accounting is to provide
information that will be helpful in decision-making.
Truly enough, financial statements are able to
provide information about the entity’s financial
position, financial performance, and cash flows.
 It is important for the owners and managers of the
entity to be able to evaluate the results of all their
business activities. This analysis can help them:

a. Confirm past expectations

b. Evaluate present financial results
c. Predict future outcomes
3
Measurement Levels
 FR
Liquidity
 Liquidity means an ability to pay as and when some obligations are due. It is the
lifeblood of any business organization because the lack of liquidity can bring bankruptcy
situation for the organization.

 The liquidity ratio measures the liquid assets of the company against the short-term
debt in an effort to see if they are in balance or if the company is overloaded with short-
term obligations.

Common liquidity ratios are the current ratio, the quick or acid test ratio, and the cash
ratio.
5
 FR
Solvency
 Solvency is the ability of the firm to meet long-term obligations and continue to run its
current operations long into the future. Solvency is one measure of a company’s
financial health, since it demonstrates a company’s ability to manage operations into
the foreseeable future.

Solvency ratios measure a company’s ability to satisfy its long-term obligations. They
provide information relating to the relative amount of debt in a company’s capital
structure and the adequacy of earnings and cash flow to cover interest expenses and
other fixed charges as they fall due.

The common solvency ratios are debt-to-asset and debt-to-equity.

6
Both investors and creditors are concerned
with the solvency of a company. Investors
want to make sure the company is in good
financial standings and can continue to grow,
generate profits, and produce dividends.
Basically, investors are concerned with
receiving a return on their investment and an
insolvent company that has too much debt
will not be able to generate these types of
returns.
7
 FR

Stability
 Stability is the ability to withstand a temporary
problem, such as a decrease in sales, lack of capital
or loss of a key employee or customer.

Stability ratios provide insights to a business’s

financial stability and security.

Analyzing your cash flow and a variety of negative

scenarios will help you determine whether or not
8
your business is financially stable.
 FR
Profitability
 is ability of a company to use its resources to generate revenues in excess of its
expenses. In other words, this is a company’s capability of generating profits from its
operations. It is one of four building blocks for analyzing financial statements and
company performance as a whole.

Profitability ratios are the evaluation method for an organization. Profit is the main
motive of every organization and these ratios help judge the organization achievement
of profits.

These are ratios that measure if a business' activities are profitable. Frequently used
ratios are the Gross Profit Ratio, Return on Assets, and Return on Equity
9
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Horizontal Analysis
 Horizontal analysis (also known as trend analysis) is a financial statement analysis
technique that shows changes in the amounts of corresponding financial statement
items over a period of time.

In Layman's term, it compares and analyzes financial results of different accounting
periods in each financial statement account and element

Example:
Percentage
2020 2019 Peso Change
Change
Cash and cash equivalents
500,000 400,000 100,000 25%

10
 Riego Salon and Spa
Comparative Balance Sheet
FR
December 31, 2020 and 2019
  2020 2019 Peso Change Percentage
ASSETS Change

Cash 500,000 400,000 100,000 25%

Accounts Receivable 58,500 90,000 -31,500 -35%
Supplies 28,000 40,000 -12,000 -30%
Land 360,000 300,000 60,000 20%
Equipment 120,000 120,000 - -
TOTAL ASSETS 1,066,500 950,000 116,500 12.26%
         
LIABILITIES AND CAPITAL        
Accounts Payable 151,500 100,000 51,500 51.50%
Notes Payable 200,000 200,000 - -
Capital 715,000 650,000 65,000 10%
TOTAL LIABILITIES AND CAPITAL 1,066,500 950,000 116,500 12.26%
11
 FR
Vertical Analysis
 Vertical analysis (also known as common-size analysis) is a method of analyzing
financial statements that list each line item as a percentage of a base figure within the
statement.

Thus, in an income statement, every line item is stated in terms of the percentage of
gross sales. Similarly, in a balance sheet, every entry is made not in terms of absolute
currency but as a percentage of the total assets.

Performing a vertical analysis of a company’s cash flow statement represents every cash
outflow or inflow relative to the total cash inflows of the company.

12
 Riego Salon and Spa
Comparative Balance Sheet FR
December 31, 2020 and 2019
  2020 2020 2019 2019 Common
Common Size Size
ASSETS

Cash 500,000 46.88% 400,000 42.11%

Accounts Receivable 58,500 5.49% 90,000 9.47%
Supplies 28,000 2.63% 40,000 4.21%
Land 360,000 33.76% 300,000 31.58%
Equipment 120,000 11.25% 120,000 12.63%
TOTAL ASSETS 1,066,500 100% 950,000 100%
         
LIABILITIES AND CAPITAL        
Accounts Payable 151,500 14.21% 100,000 10.53%
Notes Payable 200,000 18.75% 200,000 21.05%
Capital 715,000 67.04% 650,000 68.42%
TOTAL LIABILITIES AND CAPITAL 1,066,500 100% 950,000 100%
13
Analysis through
ratio
interpretation
Grumpy Cat Company decided to undergo financial analysis of their operations for 2020 and 2019. You are being hired
FR
as the financial analyst who will help Grumpy Cat understand each component better. The following information was
provided to you:

15
Current Ratio FR
is a liquidity ratio which measures a company's ability to pay its current liabilities with
cash generated from its current assets. The ratio considers the weight of total current
assets versus total current liabilities. It indicates the financial health of a company and
how it can maximize the liquidity of its current assets to settle debt and payables.

The higher the result, the stronger the financial position of the company.

Answers the question:

Can the company pay for their current liabilities with current assets?

16
Formula: FR
  𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Calculation:
  Php3,704,701
Current Ratio ,2020= =1.62
Php2,283,000
  Php3,589,755
Current Ratio ,2019= =1.48
Php2,423,000
Interpretation:
For both years, the entity’s current assets are
larger than current liabilities. The entity can
pay for their current liabilities using their
current assets since the ratio is greater than 1.

17
 FR

Remember that…
Current Ratio > 1, entity can pay current liabilities
using current assets

Current Ratio = 1, current assets = current

liabilities

Current Ratio < 1, entity cannot pay current

liabilities using current assets

18
Working Capital Ratio FR
The working capital ratio is a measure of liquidity, revealing whether a business can
pay its obligations.

The ratio is the relative proportion of an entity's current assets to its current liabilities,
and shows the ability of a business to pay for its current liabilities with its current
assets.

The working capital ratio is calculated simply by dividing total current assets by total
current liabilities. For that reason, it can also be called the current ratio

  𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝑊𝑜𝑟𝑘𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 19
 Formula: FR
  𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝑊𝑜𝑟𝑘𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Calculation:
  Php3,704,701
𝑊𝑜𝑟𝑘𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜, 2020= =1.62
Php2,283,000
  Php3,589,755
𝑊𝑜𝑟𝑘𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜, 2019= =1.48
Php2,423,000
Interpretation:
For both years, the entity’s current assets are
larger than current liabilities. The entity can
pay for their current liabilities using their
current assets since the ratio is greater than 1.

20
 FR

Remember that…
If a company's working capital ratio value is below
zero, it has a negative cash flow, meaning its current
assets are less than its liabilities. The company cannot
cover its debts with its current working capital. 

An excessively high working capital is not necessarily

a good thing either since it can indicate the company
is allowing excess cash flow to sit idle rather than
effectively reinvesting it in company growth.  21
Gross Profit Ratio FR
a profitability measure that is calculated as the ratio of Gross Profit (GP) to Net Sales
and therefore shows how much profit the company generates after deducting its cost
of revenues.

In other words, it measures how efficiently a company uses its materials and labor to
produce and sell products profitably.

Answers the question:

How much gross profit does the company makes after considering cost of goods that
were sold?   𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜= ×100 %
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 22
 Formula: FR
  𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜= ×100 %
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

Calculation:
  𝑃h𝑝 2,369,120
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜= × 100%=59.23 %
𝑃h𝑝 4,000,000

Interpretation:
59.23% of sales is the entity’s gross
profit

23
 FR

Remember that…
Gross profit ratio represents the amount of gross profit for
every Php 1.00 sale

Gross profit is very important for any business. It should be

sufficient to cover all expenses and provide for profit.

There is no norm or standard to interpret gross profit ratio

(GP ratio). Generally, a higher ratio is considered better.

A consistent improvement in gross profit ratio over the

past years is the indication of continuous improvement .
24
 FR
Net Profit Ratio
Net profit ratio is a way to measure the financial performance or profitability of a
business in relation to the costs associated with the production and distribution of
products along with other expenses

Net profitability ratios can help companies maximize efficiency and discover new ways
to improve their finances. Accountants, finance professionals and investors use net
profitability ratios to determine the financial value of a company.

  𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜= × 100 %
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
25
 Formula: FR
  𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜= × 100 %
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

Calculation:
  𝑃h𝑝1,313,077
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜= ×100 %=32.82 %
𝑃h𝑝 4,000,000

Interpretation:

A net profit margin of 33% means that for every

peso generated by Grumpy Cat Company in sales,
the company kept Php 0.23 as profit.

26
 FR

Remember that…
A high ratio indicates the efficient management of
the affairs of business.

There is no norm to interpret this ratio. To see

whether the business is constantly improving its
profitability or not, the analyst should compare the
ratio with the previous years’ ratio, the industry’s
average and the budgeted net profit ratios.
27
 FR
Receivable Turnover Ratio
The receivables turnover ratio is an accounting measure used to quantify a company's
effectiveness in collecting its receivables or money owed by clients.

The ratio shows how well a company uses and manages the credit it extends to
customers and how quickly that short-term debt is collected or is paid.

Answers the question:

How many times can an entity turn their receivables to cash for a certain period?

  𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
28
 Formula: FR
  𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

Calculation:

  𝑃h𝑝 4,000,000
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜= =5.20
𝑃h𝑝 (653,974+885,697)
2

Interpretation:

In a period, the company turns receivables

into cash 5.20 times over the whole period

29
 FR

Remember that…
A high receivables turnover ratio can indicate that a company’s
collection of accounts receivable is efficient and that the
company has a high proportion of quality customers that pay
their debts quickly.

A low receivables turnover ratio might be due to a company

having a poor collection process, bad credit policies, or
customers that are not financially viable or creditworthy.

A company’s receivables turnover ratio should be monitored and

tracked to determine if a trend or pattern is developing over time.
30
 FR
Inventory Turnover Ratio
The inventory turnover ratio is an efficiency ratio that shows how effectively inventory
is managed by comparing cost of goods sold with average inventory for a period.

Inventory turnover measures how many times a company has sold and replaced
inventory during a given period.

Answers the question:

How many times can an entity sell their inventories and have it replaced within a
period?
  𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 32
 Formula: FR
  𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Calculation:

  𝑃h𝑝1,630,880
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜= =2.27
𝑃h𝑝(677,520+756,442)
2

Interpretation:
The company’s turnover is low. Grumpy
Cat Company takes approximately 160
days to sell its entire inventory or
complete one turn

33
 FR

Remember that…
A low turnover implies weak sales and possibly
excess inventory, also known as overstocking. It
may indicate a problem with the goods being
offered for sale or be a result of too little
marketing.

A high ratio implies either strong sales or

insufficient inventory.
34
 FR
Debt-to-equity Ratio
is a leverage ratio that calculates the weight of total debt and financial liabilities
against total shareholders’ equity.

 This ratio highlights how a company’s capital structure is tilted either toward debt or
equity financing. It reflects the ability of shareholder equity to cover all outstanding
debts in the event of a business downturn.

Answers the question:

Which has more weight? Debt or Equity?

  𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜= ′
𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒 𝑟 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 35
 Formula: FR
  𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜= ′
𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒 𝑟 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Calculation:
  𝑃h𝑝 6,646,694
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 , 2020= =1.16
𝑃h𝑝5,709,522
  𝑃h𝑝 8,174,997
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 , 2019= =1.86
𝑃h𝑝 4,396,445
Interpretation:
For both years, debt has more weight than equity
since both ratios are greater than 1. However, the
decreasing ratio indicates that the entity is slowly
shifting to equity financing.

36
 FR

Remember that…
When debt to equity ratio is less than 1, equity has more
weight than debt

When debt to equity ratio is greater than 1, debt has more

weight than equity

When debt to equity ratio is equal to 1, debt is equal to equity

Rising debt ratio means the company resorts to more debt

and more interest expense

Falling debt ratio means the company is shifting more to

equity financing 37